If you’re planning to start a business or thinking about changing your business structure, you'd need to determine what will work best for you. Should you operate as a C corporation or a pass-through entity such as a sole-proprietorship, partnership, limited liability company (LLC) or S corporation? A pass-through entity means the business' income, losses, credits, and deductions are passed onto the business owner(s) personal taxes.
Currently, the corporate federal income tax is imposed at a flat 21% rate, while individual federal income tax rates currently begin at 10% and go up to 37%. The difference in rates can be alleviated by the qualified business income (QBI) deduction that’s available to eligible pass-through entity owners that are individuals, and some estates and trusts.
Individual Rate Caveats
The QBI deduction is scheduled to end in 2026, unless Congress acts to extend it, while the 21% corporate rate is not scheduled to expire. Also, noncorporate taxpayers with modified adjusted gross incomes above certain levels are subject to an additional 3.8% tax on net investment income.
Organizing a business as a C corporation instead of a pass-through entity may reduce the current federal income tax on the business’s income. The corporation can still pay reasonable compensation to the shareholders and pay interest on loans from the shareholders. That income will be taxed at higher individual rates, but the overall rate on the corporation’s income can be lower than if the business was operated as a pass-through entity.
Here are Some Other Things to Consider
There are other tax-related factors to take into consideration. For example:
If most of the business profits will be distributed to the owners, it may be preferable to operate the business as a pass-through entity (sole proprietorship, partnership, LLC, or S corporation) rather than a C corporation, since the shareholders will be taxed on dividend distributions from the corporation (double taxation). In contrast, owners of a pass-through business will only be taxed once, at the personal level, on business income. However, the impact of double taxation must be evaluated based on projected income levels for both the business and its owners.
If the value of the business' assets are likely to appreciate, it’s generally preferable to select a business as a pass-through entity to avoid a corporate tax when the assets are sold or the business is liquidated. Although corporate level tax will be avoided if the corporation’s shares (rather than its assets) are sold, the buyer may insist on a lower price because the tax basis of appreciated business' assets cannot be "stepped up" to reflect the purchase price. This can result in a much lower post-purchase depreciation and amortization deduction for the buyer.
If the business is a pass-through entity, an owner’s basis in his or her interest is "stepped-up" by the business' income allocated to the owner. This can result in less taxable gain for the owner when his or her interests in the entity are sold.
If the business is expected to incur tax losses for a while, you may want to structure it as a pass-through entity so you can deduct the losses against other income. Conversely, if you have insufficient other income or if the losses aren’t usable (for example, because they’re limited by the passive loss rules), it may be preferable for the business to operate as a C corporation, to offset future income with the losses.
If the owner of a business is subject to the alternative minimum tax (AMT), it may be preferable to organize the business as a C corporation. C-Corps aren’t subject to the AMT. Affected individuals are subject to the AMT at 26% or 28% rates.
As you can see, there are many factors involved in operating a business as a certain type of entity. This only covers a few of them. Read more about the types of business structures to consider, and consult with us when you're ready to get started. Book your first appointment for FREE, on us!